Invesco Mortgage Capital Inc.
Q1 2013 Earnings Call Transcript

Published: 2 May 2013

[Operator:]

Good morning, ladies and gentlemen. Welcome to the Invesco Mortgage Capital Inc’s investor conference call, May 2, 2013. [Operator instructions.] Now, I would like to turn the call over to the speakers for today, to Mr. Richard King, Chief Executive Officer; Mr. John Anzalone, Chief Investment Officer; and Mr. Don Ramon, Chief Financial Officer. Mr. King you may begin.

[Richard King:]

Thank you. Good morning and welcome to IVR’s first quarter earnings call. This morning, I plan to discuss first quarter results and the current positioning of the company, and then we’ll present our strategy going forward. Essentially, then, we’re going to talk about where we’ve been, where we are today, and where we’re headed. The first quarter was one in which the economy looked like it was picking up some momentum and rates rose about 30 basis points in the 10-year. Then Cypress reminded investors of the issues in peripheral Europe, March employment disappointed, and China showed signs of slowing, so we saw a partial retracement of the up move in rates in the quarter. When rates were rising midquarter, mortgages underperformed because the market started pricing [NNNs] at QE3 as well as extension risk. During that period of rising rates, specified pool payouts, that being the additional price we pay over generic TBA of the same coupon, went down as investors were less interested in prepayment protection. We took the opportunity to raise capital, and put half the money to work in specified agency pools at higher rates and lower payouts. The other half was invested in credit, RMBS, CMBS, and loan securitizations consolidated on our balance sheet. As for the financials, Q1 earnings were $0.65 per share. We paid a $0.65 dividend for the sixth straight quarter. Our book value, we saw a decline of $0.41 per share, or just under 2%, in Q1, again due to agency pay ups. And since quarter end, our book value gained back the 2%, because mortgages have outperformed [slots], pay ups on specifieds have improved, credit’s improved. We’re bullish in the near term on continued improvement in our book value. After a healthy supply of CMBS issuance caused spread softness recently, credit spreads have since retraced and in some cases they’ve tightened inside levels seen before the wave of new issuance. On a related note, after some recent weakness in the new issue RMBS AAAs, we now think that they offer attractive relative value, will perform well over the intermediate to long term. With the dearth of yield available in high-quality assets, and improvement in housing, we expect investor sponsorship should return to AAA RMBS. NIM compression is a fact of life in the agency mortgage market. Since rates have rallied back to year-end levels, and all repo rates are essentially floored, we expect that our dividend will be somewhat lower as a result of lower available reinvestment yields and our move to diversified funding and reduced rate risk. Topic two is our current positioning. IVR is well-positioned for the current environment. We’re seeing opportunities in our target asset classes, in an environment I would characterize as follows

[John Anzalone:]

Thank you, Rich. I’ll start on slide four, with the portfolio update. The total portfolio increased by 15% to over $21 billion, as our January capital raise was deployed. We kept our allocations roughly the same, as we invested half of the capital in agencies and half in credit. To that end, our nonagency RMBS holdings increased by $476 million, and our CMBS holdings increased by $324 million. I want to point out two other transactions that we completed during the quarter. We participated in our first residential loan securitization, and we have just recently closed our second, similar transaction, where we retained subordinate credit exposure in interest-only tranches. This allows us to take advantage of the strong underwriting environment while locking in structural financing by consolidating senior tranches on our balance sheet. We also issued our first exchangeable note, which had longer-term funding while reducing our exposure to repo financing. I’m going to spend a little bit of time walking through the table at the bottom of slide four. Since we have added two new sources of funding, we thought it made sense to give a little more detail on our equity allocation and leverage. The first three columns are fairly straightforward. They show the amount of repo financing that is collateralized by agencies, nonagencies, and CMBS. You can see the amount of equity allocated to each sector and the debt-to-equity ratio of each sector. Our agency allocation represents 51.2% of our equity, and has a debt-to-equity ratio of 9.1x, down slightly from 9.3x last quarter. Nonagencies represent 39.1% of our equity, and have a debt-to-equity ratio of 2.2x compared to 3.3x at year end. And CMBS represents 21.1% of our equity, and has a debt-to-equity ratio of 2.9x, which was unchanged from last quarter. The unconsolidated ventures, which represents our investment in the Invesco mortgage recovery fund, is not levered, and represents 1.2% of equity. The residential loans column shows our investment of $31.2 million in subordinated bonds and [IOs], and also shows the $374 million of senior asset-backed securities that were consolidated on our balance sheet. This represents 1.1% of equity and a debt-to-equity ratio of 12x, but keep in mind the important distinction that this is structural leverage and not refinancing, thus the assets and liabilities are matched, and there is no margin call risk. Finally, the corporate liability column represents our exchangeable note. We isolate this financing because it represents funding at the corporate level, and is not subject to margin call risk. So putting all the pieces together, our overall debt-to-equity ratio is at 6.4x. This is up slightly from last month, but the financing mix has changed and our exposure to repo financing has been reduced. Moving to slide five, and agencies, we continue to focus on prepayment protected 30-year collateral, which represents almost 80% of our agency book. These bonds continue to exhibit stellar prepayment protection, as our 30s paid at 9.5 CPR for the quarter. Net yields increased by 16 basis points, as borrowing costs were lower on new purchases due to forward starting [slops]. That cost of funds number will increase as we begin to pay on those slops. Moving to slide six, in nonagencies, as I mentioned earlier, we increased our nonagency portfolio by $476 million. These purchases were concentrated entirely in the prime and [unintelligible] sectors, which reduced the re-remic portion of our portfolio to just under 50%. Nonagencies had a strong quarter, with prices on our legacy securities up over $2 on average for the quarter, and another $0.75 on average since quarter end. We’re still positive on nonagencies, as housing fundamentals continue to improve and technical remain very supportive. Also, we like the fact that these bonds have a favorable return profile in a rising rate environment, as coupons would reset higher on hybrid [unintelligible] collateral and we would expect higher rates to be associated with the continued recovery in housing, corresponding to lower expected losses on the securities. Finally, slide seven and CMBS. Our CMBS grew by $324 million during the quarter, with our purchases focused on new issue 2.0 subordinates. CMBS [unintelligible] had a very strong first quarter, with our prices up nearly a point on average, and they’ve even done better to start off the second quarter with our more recent 2.0 positions up 2.5 points on average and legacy bonds up over a point. We continue to like the CMBS sector as support of technical. Like nonagency, there is negative net supply here, and continued improvement in CRE fundamentals have led investors to seek yield in the sector. With that, that concludes our prepared remarks, and I’ll open the floor for questions.

[Operator:]

[Operator instructions.] Our first question does come from Mike Widner of KBW. Your line is open.

[Michael Widner:]

Let me just ask one thing. In the nonagency RMBS that you guys are putting capital in today, you tend to be sticking very high in the credit stack, and that’s kind of been your model. And at the same time, you’re talking about [mes] financing and going forward, retaining subordinates on new issues. Just wondering if you could talk about why the difference there. Why not moving deeper into credit on existing legacy RMBS and getting into subprime and [mes] and junior tranches and that sort of thing.

[Richard King:]

The answer really has to do with the underlying loans. Essentially we like to lend against good assets, and when you look at the subprime market, there are a lot of unpredictable factors like servicer behavior, among other things. And so you have the cliff risk there, versus underwriting strong borrowers, below 70 loan-to-value, who are just strong borrowers and good loans, where we believe we can predict the likelihood of a default. So we have a lot more confidence buying subordinate bonds backed by strong loans, rather than backed by really questionable loans.

[Michael Widner:]

Just wondered if you could maybe state again or elaborate a little bit on some of the comments you made, or implications you made, regarding the dividend. And as I was listening to the call, it seems like you were talking about spread compression on agencies and moving a fair amount of your funding base, you know, to permanent financing, and both of those having negative impact on net interest spreads. And so just wondering if you could elaborate a little bit on what you see as the dividend implications for that.

[Richard King:]

We recognize the value of a stable dividend, and we’ve managed to keep it steady for six quarters. And we’ve been able to keep it steady by moving the most attractive assets and putting new capital to work at advantageous times. But as we sit here today, yields are lower across all sectors, and the longer yields stay down, NIM compression kind of becomes a fact of life. And we were seeing rates begin to go up, and get better reinvestment yields, but since rates rallied back to the lower levels, could see prepays pick up a little bit as a result. And I mentioned that repo rates are essentially floored. So I think everybody’s seen that over the last number of quarters, what people tell us they believe our core is is in the lower than 65, right? So if we see opportunities to put on assets at better yields than the existing portfolio, obviously we’re going to do that. But I think given that we have seen some consistency and earnings taking out gain on sale, lower than 65, I think it’s reasonable to assume that the dividend could be lower. And despite current return profiles, we like the strategy we have. We think we’re going to reduce risk. So in other words, we’re not going to generate a lower return at the same level of risk. We’re going to maybe have a slightly lower dividend with less risk and less reliance on short term financing and some of these opportunities that really we think are going to be present for a long time, that being like risk sharing, CRE loan opportunities, and certainly residential securitization.

[Michael Widner:]

And then I guess just one real quick one. You mentioned the kind of core earnings power kind of being below 65, kind of right around $0.60 less, a couple quarters. Would you envision, given the moving pieces that you’re talking about, sort of that to be indicative of the run rate? Or are you sort of hinting toward maybe even drifting from there?

[Donald Ramon:]

We really don’t want to get into forecasting [revenue]. As you know, we generally target paying out all of our taxable earnings on an annual basis, so that’s what we’ll look at as what we think the earnings are going to be throughout the rest of the year, and certainly dividends will always reflect that number. But again, I think it’s indicative. We’re not far off where we’ve been, if you extract the gain on sale from the earnings, and I think that on a go forward basis, it’s still going to be a very competitive dividend. It just might come down a little bit, just like others have had to do over time.

[Michael Widner:]

Well, certainly we’ve seen them come down across the group, and you guys are above most of the group. So appreciate the comments, and it’s unfortunate you won’t do my job for me, but I guess I can take that and run with it.

[Donald Ramon:]

Okay, thanks, Mike.

[Operator:]

Our next question does come from Douglas Harter of Credit Suisse. Your line is open.

[Douglas Harter- Credit Suisse:]

I was hoping you guys could talk a little bit about the returns that you see on the new issue securitizations that you’re doing, and sort of how you compare those to other credit assets that are out there.

[Donald Ramon:]

I would say on the securitizations, really the return profile is not all that different than what we’re seeing in the securities space. So it’s really just a way to get exposure to newly underwritten credit, that we like quite a bit. So I wouldn’t say it’s all that different than where we are purchasing bonds.

[Douglas Harter- Credit Suisse:]

And you guys talked a little bit about putting on some direct commercial real estate loans. I guess when should we start to see those become a meaningful part of the balance sheet?

[Richard King:]

Actually we closed our first one in late April, and we’re really optimistic about that market. We spoke about the kind of lull in maturities, and I think it’s one that’s going to go on for quite a while and it will build as a percentage of our capital over time. But the first one was very attractive.

[Douglas Harter:]

And do you plan to use the corporate debt to finance that?

[Richard King:]

Yeah, exactly. I think it makes a lot of sense to kind of leverage the returns that we can get there and create double digit returns through the issuance of some type of notes. And again, it’s another way to reduce interest rate risk and repo margin call and all those risks.

[Operator:]

Our next question does come from Trevor Cranston at JMP Securities. Your line is open.

[Trevor Cranston:]

Just following up a little bit more on some of the new opportunities. Can you guys share your current thoughts on where you think we are in the process of the GSEs selling some credit bonds, and any implications that there might be to that program or the timing of that from the change in the FHFA director?

[Richard King:]

The government clearly wants to reduce their role. We talked about that. And really, there are two ways that they can do it. One is by essentially not guaranteeing loans. And the other is by guaranteeing fewer loans. And so they’re going to guarantee fewer loans, and the loans that they do guarantee, they plan to risk share on. And so we think that obviously this year the FHFA has put out a goal of essentially $60 billion, $30 billion in each agency, of risk sharing transactions and then moving to a percentage of production next year, from what we understand. And I’m sure it will be a measured and careful pace, but we would expect that there will be transactions done as soon as the third quarter. And I think they’re going to look at multiple forms of risk sharing at the loan level and at the full level, in various forms. You know, senior subordinate and credit linked. And so I think that’s going to be a huge opportunity. I think it will start in the third quarter. It could get pushed back, but all indications are it will definitely be this year. And we’ve really seen progress there. The agencies each have come out and announced loan level details that help in underwriting that risk. And we think that there are a lot of benefits. For us, it’s another forum that we can use to essentially get structural leverage that is not subject to interest rate risk and margin call and all those things. And there are a lot of details to be worked out, and I’m sure there will be many different versions of it.

[Trevor Cranston:]

And just on the potential for a new director of the FHFA, do you guys foresee any changes to HARP or any new refi programs coming down the pipeline that you’re concerned about at all?

[John Anzalone:]

You know, a couple of things on the possible director replacement. First, it’s a big hard to handicap the likelihood of confirmation. It’s likely to be a pretty contentious process. So obviously us and everyone else is going to look at that really closely over the next couple of months. We don’t anticipate any huge impact to our book. We think that from what we’ve seen, there hasn’t been a lot of indication that moving the HARP date would probably be the biggest risk. But even there, we’ve been much more focused on prepayment protection, regardless of HARP date, and it’s worked out well, so I wouldn’t expect a huge impact there. But it kind of remains to be seen as we go forward. I think there might be more focus on kind of modifications, things like that, which would obviously have a little bit less impact on our portfolio.

[Operator:]

Our next question does come from Joel Houck at Wells Fargo. Your line is open.

[Joel Houck:]

Just a couple of questions on this residential loan securitization. Can you talk about who you sourced the loans from? Which originator? Was it multiple originators? Was it one source?

[John Anzalone:]

It was multiple originators.

[Joel Houck:]

Was there a predominant originator in the deal?

[Donald Ramon:]

The challenge we have, again, it’s a private deal. We can’t give a whole lot of information about the structure of that. Getting into the deals on who’s sourcing, and so forth, again, we don’t have reps and warrants risk associated with that. So it’s really not anything to be concerned about, from our standpoint, and what investors should be looking at from our standpoint, when they look at IVR.

[Joel Houck:]

Can you say whether it was bulk or flow purchases?

[Donald Ramon:]

It’s bulk.

[Joel Houck:]

Okay. And it looks like, based on the balance sheet disclosure, you kept about 8% of the deal. I’m just subtracting off the securities issue versus the asset. Is that math right?

[Donald Ramon:]

Yeah, that’s probably about right.

[Joel Houck:]

And in terms of the gain on sale of investments of $6.7 million, what is the contribution to this securitization this quarter?

[Donald Ramon:]

There’s none. The gain on sale, that’s the normal flow of when we move in and out of our MBS securities, so it had nothing to do with the securitization transaction.

[Joel Houck:]

Okay, so there was no gain on sale generated from the securitization?

[Donald Ramon:]

That’s correct.

[Joel Houck:]

And I guess a related question, can you talk about the swaps you added in the quarter, dollar amount, tenure, things like that, and what did it do to the net duration at the end of March, versus the end of December?

[Donald Ramon:]

If you look at the press release, we’ve got a table of what swaps are there. You can see which ones were added at the bottom. And you can see that they’re generally longer-dated swaps going out as far as ten years, and forward starting. Some of them not even starting until 2015. But all of that, if you look at the press release, you can see those things outlined there. John, do you want to talk about the duration?

[John Anzalone:]

Yeah, so the goal of putting the swaps on was to keep the duration gap in line with where it’s been. So still, in terms of where we’re targeting our duration, our model duration gap of about a year, to a little bit more than a year. But as you can see, our book value has been pretty stable, so empirical durations of our portfolio have been closer to zero. We’ve seen a little bit of movement in book value, but it’s been pretty stable over the course of the year.

[Joel Houck:]

And then Don, to your point, I’m looking at the table, there’s seven footnotes. Are those the ones that were added?

[Donald Ramon:]

Well, not all of them. And I don’t have it broken down. Just compare it to the last quarter. But generally, the ones at the bottom, I think if you looked at items, if I remember correctly, it’s the last four on that list. The four starting are the ones that we added during the quarter.

[Operator:]

Our next question comes from Cheryl Pate of Morgan Stanley. Your line is open.

[Cheryl Pate:]

Maybe we can get some more color on the type of loans that have gone into the residential loan securitizations? Are they more jumbo-oriented? Or conventional?

[John Anzalone:]

They’re all jumbo, 30-year fixed loans.

[Cheryl Pate:]

And then on the nonagency side, can you just give us a sense on what the current yields are on the new issue stuff that you’re putting on versus the legacy portfolio? And how much more of the hybrid ARM resets should we expect over the next couple of quarters?

[John Anzalone:]

I’ll start with the legacy nonagency yields right now that we’re seeing. So if we were to buy, say, a new prime secondary deal, we’re talking yields in the 3.5% to maybe 4.25% type range. I’ll say yields are maybe 50 basis points higher than that, in that space. In terms of securitization, it’s…

[Richard King:]

Much more of an IRR-type calculation, where we’re looking at what we’re paying for the pool, and then where we’re still in AAAs. And so we’re looking at each of those opportunities on a levered gross ROE kind of basis, and I think as John said earlier, we’re seeing that the return profiles are similar, but we prefer the loan securitization from an overall risk-adjusted return standpoint, because there’s no margin call, it’s locked-up financing, there’s no gap, as he said. So we think it’s a very attractive space.

[Cheryl Pate:]

And then just on the nonagency portfolio, what percentage of that would be sort of hybrid ARMs, and what’s sort of the forward look on resets on the next…

[John Anzalone:]

I think in our legacy book, the vast majority is hybrid ARMs. And I would say the resets on those, a lot of those are going to be already heavy reset, so if they’re going to reset every year in terms of that. A lot of those loans aren’t in the fixed part of the hybrid ARM version right now. So they’re already indexed to a large degree.

[Operator:]

Our next question does come from Dan Furtado of Jefferies. Your line is open.

[Dan Furtado:]

I have just a couple of relatively minor questions. The first is why did you execute the deal in the private market? It feels like you potentially could have gotten better pricing if you would have gone on the public market with the securitization.

[John Anzalone:]

That’s just not what we see. I think levels really aren’t much different between private deals and public deals.

[Dan Furtado:]

And if they’re not that much different, why go one path versus the other?

[John Anzalone:]

It’s just a simpler process for us.

[Dan Furtado:]

And then did you disclose what the AAAs priced you to benchmark swaps on that deal?

[John Anzalone:]

No, we didn’t disclose that.

[Dan Furtado:]

And then my last question is just to understand the process a little bit better, was this a transaction in which you brought the loans to the investment bank? Or was this a transaction where you showed up to the bank and they had the loans ready for packaging?

[John Anzalone:]

It was the latter.

[Operator:]

Our next question does come from Dan Altscher of FBR. Your line is open.

[Dan Altscher:]

I wanted to ask about the CPRs, in particular in the nonagency side. You saw them tick down a bit to the 15.5. Is that a result of lower actual voluntary prepaid? Or is it maybe just a sign of lower realized credit losses there?

[John Anzalone:]

I think it was more a reduction of voluntary prepays, I would say. But keep in mind, our legacy book now has moved up in price enough that it’s much closer to par now, so the impact of CPR in that book is reduced in terms of its impact on returns.

[Dan Altscher:]

And then also, kind of vice versa, on the 15-years, those ticked up a bit to 18.5, which I guess is a little bit contrary to some of the other indications that we’ve seen that prepays were generally down across fixed rate. Is that just the predominance of higher coupon bonds that are remaining?

[John Anzalone:]

A couple of things. One, the 15s that we own, we haven’t been very active in 15s lately. They’re mostly older bonds that were prepay protected. But they’re definitely higher coupons than say just the universe of 15s. So they ticked up a little bit. But they’re only about 17% of our agency book at this point. So overall, the impact on the portfolio wasn’t that great from those.

[Dan Altscher:]

Now that we’re through the first month of the quarter, can you give us a sense of where you think the book value might be marking to?

[John Anzalone:]

I think Rich mentioned on the call, we’re basically back to year-end levels.

[Operator:]

At this time, I show no further questions.

[Richard King:]

Thanks, everybody. Appreciate it.